Financial Fine Print 110 cash to other uses. Companies that can’t come up with the cash have to pay a penalty to the Pension Benefit Guaranty Corp. (PBGC), a federal agency that guarantees pension benefits. Most compa- nies try to avoid this at all costs, because the PBGC doesn’t give the money back once the plans come back into compliance. Pension rules also can require some companies with underfunded plans to take a charge to equity, yet another reason why shareholders need to pay attention to this footnote. In 2002, approximately 325 companies in the S&P 500—90 percent of the companies that offer pension plans—reported underfunded plans, up from 240 in 2001 and 118 in 2000, accord- ing to CSFB accounting analysts David Zion and Bill Carcache. As a result, companies in the S&P 500 ponied up approximately $46 billion in cash, more than three times as much as the $15 billion contributed in 2001. 4 Of course, in Pension-land, even this additional cash infusion can be confusing because companies that have the money to pump into their pension funds get a tax break and also can book the added income at whatever rate of return they’re using. At GM, for example, using its announced 10 percent return on the $4.8 billion it added to its pension funds in 2002 automatically gener- ates an additional $482 million in operating income for the com- pany. At IBM, which said in December 2002 that it was pumping $4.2 billion into its pension funds, the contribution was expected to add about $350 million in operating income. Indeed, despite their big funding gaps, Pat McConnell, senior accounting analyst at Bear Stearns, says that neither GM nor IBM was required to pump additional money into their pension funds in 2002. “They get a tax deduction when they make a contribution and the earnings grow tax-free,” says McConnell. Some analysts c07.qxd 7/15/03 10:05 AM Page 110 Pensions in Wonderland 111 compare such contributions to individuals making extra payments on their home mortgages. But analysts note that companies that don’t have the cash to spare, including most of the major airlines, could find themselves in a cash crunch, which would impact their credit ratings and, in a worst case scenario, have the potential to send the companies into bankruptcy. Companies whose pension obligations exceed their market capitalization are a particular cause for concern. For 2002, Credit Suisse’s Zion was predicting that the pension obligations at 31 companies would exceed the company’s market capitalization. At the top of the list was AMR Corp., where the pension obligation was nearly nine times greater than its market capitalization at the end of 2002. Several analysts note that large underfunded pension plans combined with huge other postretirement benefits, primarily health insurance for retirees, were the motivating factors behind many large steel companies filing for Chapter 11 reorganization. The bankruptcy filings—at Bethlehem Steel and National Steel among others—enabled the companies to renegotiate their pen- sion obligations. One company, LTV Corp., filed for Chapter 7 protection in December 2001, instantly wiping out pensions and health coverage for its retirees. 5 Two large airlines—United and US Air—began seeking pension concessions after both filed for Chapter 11 reorganization in 2002. And given the state of pension funding at several other large airlines, including American and Delta, analysts believe this may be an option for these carriers too. Ratings agencies like Moody’s and S&P consider pension obli- gations to be similar, though not identical, to debt and have begun to look at the pension fine print a lot more closely. Among those c07.qxd 7/15/03 10:05 AM Page 111 Financial Fine Print 112 Most of the companies that provide pensions also provide health insurance to retirees and their families. Unlike pensions, which companies are required to fund and for which they receive substan- tial tax breaks, these retiree health benefits are largely unfunded. But just like pensions, the accounting is basically the same and the obligations are just as real. For both obligations, only part of the expense is reflected in the balance sheet, so investors need to turn to the pension footnote to find out the details. In the fine print, these benefits are called “other post-employee benefits,” or OPEB, and they’re often pretty sizable. At General Motors, postretirement obligations stood at $57.5 billion at the end of 2002, compared with $52.5 billion in 2001. But OPEB assets were only $5.8 billion for 2002, a funding level of just over 10 percent. GM estimates that it provides postretirement benefits to around 460,000 retirees and their surviving spouses. According to The Wall Street Journal, GM is the largest private purchaser of healthcare in the United States. The company spends about $1,500 a year, about $690 million, just to provide prescription drugs to each of its retirees, including $55 million a year just on the heartburn drug Prilosec. * Although GM began instituting cost- saving measures in the early 1990s—salaried employees hired after 1993 can no longer get GM health insurance upon retire- ment, and many salaried workers pay more for their benefits— costs are still climbing as healthcare gets more sophisticated and workers live longer. * “Golden Years? For GM’s Retirees, It Feels Less Like Generous Motor,” The Wall Street Journal, February 21, 2003, p. A1. IN FOCUS c07.qxd 7/15/03 10:05 AM Page 112 Pensions in Wonderland 113 downgraded in late 2002 were GM, Ford, and Navistar Interna- tional. In bankruptcy filings, pension liabilities are treated as unse- cured debt. “When you have a big pension obligation coupled with a lot of leverage on the balance sheet and the company isn’t generating cash flow, that’s a pretty volatile combination,” says Zion. RATING THE RATE One of the next things individual investors should focus on is the fictional interest rate—called the expected rate of return in the fine print. This number usually appears at the very end of the pen- sion footnote, which makes it easy to get lost in all of the other numbers. From Chapter 2, we know that many pros, including Jim Chanos and Robert Olstein, use this rate as a quick gauge to deter- mine whether the company is being overly aggressive in its accounting. The nice thing about looking at this rate is that it pro- vides a quick flashpoint without having to go into the nuances of pension accounting. In 2000 and 2001, when the S&P 500 index fell 10.1 percent and 13 percent respectively, the S&P 500 companies assumed that their pension plan assets grew by an average of 9.2 percent. Companies argue that their rates reflect long-term annual returns of 10 percent for stocks and 6 percent for fixed income invest- ments. A typical pension fund might have 65 percent of its portfolio in stocks and the remaining 35 percent in fixed income products. But in 2002, the average pension fund declined by about 8 per- cent, according to several analysts’ estimates, creating a growing gap between expected and actual pension returns. c07.qxd 7/15/03 10:05 AM Page 113 Financial Fine Print 114 “The rate of return is still too high,” says Olstein. “It should be 6 percent.” That’s a view also held by Warren Buffett, who has repeatedly criticized companies for setting their rates too high. In 2001, he even suggested that companies with overly optimistic rates were exposing themselves to litigation for misleading investors. 6 In 2001 Buffett lowered Berkshire Hathaway’s expected rate of return to 6.5 percent from 8.3 percent a year earlier. While few followed Buffett’s lead, many companies began lowering their rates in 2003, in part prompted by SEC comments that it planned to take a close look at companies whose rates came in above 9 percent. When the expected rate of return falls, the pension expense increases. Reducing the expected rate of return by 1 percent for the S&P 500 companies would cause that expense to climb by about $10 billion. Dropping the rate all the way down to 6.5 per- cent—an almost unimaginable scenario—would cause pension expense at the S&P 500 companies to rise by $30 billion, accord- ing to an analysis by CSFB. In addition to the expected rate of return, investors also should do a quick reality check on the discount rate that companies use. The discount rate is used to calculate the pension benefit obliga- tion (PBO) and should be close to the yield on high-grade 10-year corporate bonds, which at the end of 2002 was around 6.6 per- cent. Companies don’t have nearly as much flexibility with this figure as with the expected rate of return, but it still pays to take a quick look. When the discount rate falls, the pension obligation increases. Taken together with higher pension expenses because of lower rates of return, this creates a double whammy for many companies. c07.qxd 7/15/03 10:05 AM Page 114 Pensions in Wonderland 115 A SMOOTHING EFFECT ON INCOME The reason why accounting rules allow companies to pick their own interest rate and assume that their pension funds grew by that amount is called “smoothing” in accounting-speak. In the fine print, it’s often called by its proper name, FAS 87. The rule was designed to prevent a sudden shock to earnings if a company’s pension assets either fell or rose sharply one year due to stock market fluctuations. When the stock market is rising, as it was for much of the 1990s, the smoothing rule ensures that companies aren’t automat- ically booking gains in their pension plans as income. When the market is falling, as it began doing in 2000, smoothing means that pension fund decreases don’t immediately contribute to losses. Instead, both gains and losses are deferred over time using a com- plicated formula. During a prolonged bull market, some of that income does turn into earnings for the company, making results look better than they really are and, in some cases (see Exhibit 7.2), enabling a company to report a profit when it otherwise would have reported a loss. But when the market declines, the artificial earnings sweet- ener slowly begins to disappear, which can cause companies to report lower earnings. Even though these are just accounting expenses—something companies routinely point out to make them seem less important—instead of actual cash expenses, they still can have a very real impact on earnings. In early January, for example, GM said it expected 2003 earnings to decline by 25 per- cent because of sharply higher pension costs. As a result, many analysts believe that smoothing can be very deceptive to investors, particularly those who just focus on head- c07.qxd 7/15/03 10:05 AM Page 115 Financial Fine Print 116 line numbers, such as net income. The only way to figure out how much of a company’s net income is coming from its pensions is to read the fine print. (See Exhibit 7.2.) “The valuations for some companies might not have been as high if investors had focused on the fact that these were hypo- thetical returns,” says McConnell. “Accountants shouldn’t be doing smoothing. The company should report what really hap- pened.” Even operating income, which many pros and more sophisti- cated investors tend to focus on more heavily because they con- sider it to be a more accurate number than net income, can be positively impacted by pension income. When the expected rate of return is rising, pension expenses fall, which helps operating income. (See Exhibit 7.3.) Problems begin when the expected rate of return starts to fall, as it began doing in 2000, causing pension expenses to increase. Even when pensions account for less than 20 percent of oper- ating income, some money managers say they’re still concerned, because the earnings are not real, no matter how solid they look. To figure out the true pension impact, they crunch a few numbers, deducting pension income and service costs from operating income, which eliminates the positive impact of pension income. Analysts who track pension issues say investors should be con- cerned if 20 percent or more of operating income is coming from pension gains. R ED F LAG c07.qxd 7/15/03 10:05 AM Page 116 Pensions in Wonderland 117 Nothing But Net? Pension income accounted for 20 percent or more of the reported net income of these companies. Pension income enabled the first six listed to report net income in 2001 when they otherwise would have reported a loss. At three companies—Verizon, Meadwest- vaco, and Northrup Grumman—pension income accounted for 20 percent or more of net income during each of these three years. Company 2001 2000 1999 Raytheon 3718% 24% 2% Lockheed Martin 291 NM 8 Verizon 204 21 21 TRW 164 26 18 Kodak 147 6 2 Whirlpool 134 17 (4) * Meadwestvaco 99 28 48 El Paso Corp. 52 5 NM Northrup Grumman 51 48 48 Pactiv Corp. 45 62 NM Weyerhauser 43 15 11 Textron 38 20 2 NCR Corp. 36 45 12 ConEd 29 24 0 Boeing 21 13 4 Norfolk Southern 21 6 24 Bellsouth 20 11 8 Eaton Corp. 20 7 1 Donnelly & Sons 20 6 3 Source: Credit Suisse First Boston, “The Magic of Pension Accounting,” September 2002, p. 76. NM = not material. * In 1999, Whirlpool reported net pension expense. EXHIBIT 7.2 c07.qxd 7/15/03 10:05 AM Page 117 Financial Fine Print 118 Dave Halford, a certified public accountant and equity portfolio manager for Madison Investment Partners and the Mosaic Fund Group, said that for years IBM and General Electric have been generating 5 to 10 percent of their operating income from pen- sions. “The only way you’d know it is to go to the footnotes,” says Halford. “The company is not usually going to reference it unless they’re questioned.” In 2002 and 2003, several large institutional investors as well as individual investors began pressuring companies to exclude pen- sion income when it came to setting executive compensation. In February 2003, facing a shareholder proposal put forth by the Communications Workers of America, General Electric said it would no longer count pension income gains when calculating its executives’ compensation packages. Other companies that have generated income from their pension funds, including IBM, faced similar shareholder proposals at their annual meetings during the spring of 2003. As some companies began to reduce their pension assumptions in late 2002, analysts who follow pension issues began focusing on the impact this reduction was likely to have on future earnings. Some analysts even compared the rosy pension returns that com- panies had used to pump up earnings to a narcotic-like substance that would make it hard for companies to go cold turkey. Weyerhauser, for example, used an 11 percent rate of return in 2001, enabling the company to report a big pension gain, which in turn substantially helped both net and operating income. As shown in Exhibits 7.2 and 7.3, pension income accounted for 43 percent of Weyerhauser’s net income in 2001 and 26 percent of operating income. Many other companies also rely on high rates. Air freight carrier FedEx assumed a 10.9 percent rate of return c07.qxd 7/15/03 10:05 AM Page 118 Pensions in Wonderland 119 between 1999 and 2001. Reducing the interest rate causes pension expenses to rise, which in turn causes earnings to fall. According to the CSFB study, 337 companies in the S&P 500 were expected to have higher pension expenses in 2003 than in 2002. At GM, for example, pension expenses were projected to increase by $2.2 billion between 2002 and 2003 based on an 8.5 percent return. (GM said during a conference call on January 9, Better Than It Seems At these 12 companies, at least 20 percent of operating income came from pension funds in 2001, masking the company’s true results. Two companies—Prudential and Allegheny—would have reported operating losses in 2001 without the benefit of their pension fund assets. Company 2001 2000 1999 Prudential Financial 109% 30% 5% Allegheny Technologies 102 49 51 Unisys Corp. 63 25 11 NCR Corp. 53 46 30 Meadwestvaco 41 20 46 McDermott Int’l 36 267 7 Raytheon Co 36 11 1 Northrup Grumman 34 42 36 Pactiv Corp. 28 28 27 Weyerhauser 26 11 8 Lockheed Martin 23 19 5 Boeing 20 12 4 Source: Credit Suisse First Boston, “The Magic of Pension Accounting,” September 2002, p. 78. EXHIBIT 7.3 c07.qxd 7/15/03 10:05 AM Page 119 [...]... Dave Halford, an equity portfolio manager for Madison Investment Advisors and the Mosaic Fund Group, a highly respected fund “And there was not a lot of difference between what Enron was doing and what other companies were doing.” As a result, Halford 1 27 Financial Fine Print What Is a Special Purpose Entity? An SPE is a separate corporate structure financed through debt taken on by a particular company,... other real estate obligations for its new headquarters in Sunnyvale, California Yahoo! was hardly the only company to push real estate obligations off of its balance sheet, although the company’s claim of no debt, while technically accurate, certainly seemed a bit brazen in the post-Enron world Hundreds, if not thousands, of publicly traded companies structured similar real estate transactions and crafted... pretty clearly for the first time,” says Jim Mountain, a partner at accounting firm Deloitte & Touche “You can’t speculate, but investors may hear some fairly dramatic numbers in narrow, isolated circumstances.”4 Why should individual investors care about off-balance sheet obligations? Because they can mask a company’s true financial condition, making it look stronger than it really is Pushing debt and other... times in its 2001 annual report, Yahoo! noted its strong balance sheet and the $1.5 billion in cash and marketable securities it had on hand In his letter to shareholders, Yahoo! Chairman and Chief Executive Officer (CEO) Terry Semel even bragged that the company had “no debt”—another big positive that set Yahoo! apart from many of the Internet companies that had already failed and those that were still... remain off the parent company’s books) The remaining 97 percent is financed and becomes an obligation for the company —albeit one that remains off its balance sheet New rules issued by the Financial Accounting Standards Board (FASB) in January 2003 bump up the minimum investment requirement to 10 percent and require companies to place most SPEs back on their balance sheets, making them much less attractive... the interest rate might have on plan assets and obligations (See Exhibit 7. 4.) As at most major airlines, pensions are a significant item at Continental And the sharp decline in pension assets and lower interest rates couldn’t have come at a worse time, with so many airlines cash-strapped in the wake of the September 11 terrorist attacks, not to mention the sluggish economy and a war in Iraq To find out... Debt by Many Other Names designed deliberately so that public companies would not have to reveal things they’d rather keep secret Enron, of course, was the most famous example of how offbalance sheet obligations can really wreak havoc A 2,000-page report released in March 2003 by a U.S bankruptcy court examiner found that the company had created hundreds of off-balance sheet transactions, enabling it... and Analysis (MD &A) section and in the footnotes, though it will rarely be concentrated in one place To appreciate how much things have changed in the postEnron world, compare a 10-K for 2002, the first year that some companies really began providing details on their off-balance sheet obligations, to one from 2000 It will be relatively easy to spot some big changes at many companies 129 Financial Fine. .. that are on a calendar year, the new rules take effect in the fall of 2003 In its new rule, known as FIN 46, FASB even coined a new name, variable interest entity, which broadened the definition of off-balance sheet transactions, making it harder—at least in theory— for companies to continue keeping these deals off of their balance sheets The new rules also require that any company that has the majority... survive.1 And indeed there was no debt on Yahoo!’s balance sheet, at least as far as accounting rules were concerned But the company did provide a helpful hint to investors in its “Committments and Y THE SPRING 125 Financial Fine Print Contingencies” footnote that it had some sizable debt-like obligations—items that credit rating agencies like Standard and Poor’s (S&P) and Moody’s treat as if they were liabilities . EXHIBIT 7. 2 c 07. qxd 7/ 15/03 10:05 AM Page 1 17 Financial Fine Print 118 Dave Halford, a certified public accountant and equity portfolio manager for Madison Investment Partners and the Mosaic Fund Group,. Financial Fine Print 110 cash to other uses. Companies that can’t come up with the cash have to pay a penalty to the Pension Benefit Guaranty Corp. (PBGC), a federal agency that guarantees. individual investors care about off-balance sheet obligations? Because they can mask a company’s true financial condition, making it look stronger than it really is. Pushing debt and other obligations